The Strategic Profit Model

The Strategic Profit Model (SPM), also known as the Dupont Financial Model, represents the combination of the income statement and the balance sheet into a single model. The model relates three measures of profitability: net profit margin, invested capital and return on equity which are then related to the two measures of productivity: asset turnover and financial leverage.

Strategic Profit Model Results for 2012

By John S. Strong and Lawrence J. Ring

As in past years, we have updated our review of Strategic Profit Model results for retailers for 2012. The results presented in this article refer to Fiscal Year 2012, which for most U.S. retailers ends in January 2013. These annual reports are typically released in the subsequent April-May 2013 timeframe. Many international retailers have fiscal years which end in June, with results released in September-October. The results presented here thus represent the most recent full-year data.

A year ago, we wrote that after four years of a deep recession and some signs of recovery in 2010, retail moved sideways in 2011, with mixed results across consumer segments and retail formats. There were only a few star performances. In contrast, many turnarounds appeared to founder, while a number of large, iconic retailers reported very weak results and trading environments that threatened their longer-term prospects.

This same story has continued through 2012. Aggregate results were better than in 2011, with retail seeing improvements in financial performance. In many cases though, sales growth was achieved only as a result of lower margins. At the company level, 2012 results were again mixed.

U.S. Retailers

As we reported last year, the economic downturn forced retailers toward a different model for generating returns. The model of the early 2000s was built around sales growth, fixed cost leverage, and substantial use of debt to generate high returns on equity. The changed economic environment required a strategy of profitability based on productivity, not growth. It also required more emphasis on returns on capital, as markets have much more conservative views about the appropriate level and potential consequences of high leverage. By 2010, the results of these efforts began to bear fruit: for 71 of the largest publicly traded retailers, 2010 sales were up 3.9% but profits increased 20% (compared with 2009). Then, after moving sideways in 2011, overall results recovered in 2012.

Table 1

Table 1 shows the Strategic Profit Model results for 2012 for the 71 largest public U.S. retailers, based on sales. (Sales for these companies are approximately $2 billion or greater, and represent about 58% of U.S. retail sales excluding motor vehicles.) Sales increased 4.2% to $1,808 billion, while net income increased 16.3% to $58.2 billion.

For our overall set of 71 U.S. retailers, Return on Sales (ROS) rose to 3.2% in 2012 from 2.9% in 2011. Asset productivity (Sales: Assets) decreased slightly from 2.09 to 2.02, but this was not enough to offset the improvement in profit margins. As a result, Return on Assets (ROA) increased to 6.5% from 6.0%. Spurred in part by growing share repurchases and concerns about rising interest rates, leverage (measured as Assets: Equity) grew for the first time since 2008, rising from 2.43 in 2011 to 2.67 in 2012. As a result, Return on Equity (ROE or RONW) rose from 14.7% to 17.4%. In sum, profit margins were up substantially, asset productivity remained about the same, and leverage increased for the first time since the global financial crisis.

This overall improvement in profitability and returns masked the fact that the results for individual companies were much more of a mixed bag. While 51 of the 71 retailers showed sales increases, only 33 of 71showed increases in Return on Sales; only 32 of 71 showed improved Return on Assets, and only 31 of 71 increased their Return on Equity. For a majority of these retailers, sales growth came at the expense of financial performance.

As was true in 2011, the most significant result continues to be the explosive growth of Amazon. Sales grew 27% in 2012 to $61 billion. The 2012 absolute sales increase of $13 billion was exceeded only by Walmart, a company 10 times larger in revenues. Amazon is now the 10th largest U.S. retailer by revenues. Amazon’s business model continued to evolve, with new online stores, products and services—some of them proprietary such as the Kindle, while others are third-party sellers operating through Amazon websites (Amazon Marketplace). The company’s strategy of price, selection, and service was extended to more countries; international sales are now 43% of total revenues.

Amazon’s sales have tripled since 2008, but this growth has been achieved without accompanying profitability—net income fell from $645 million in 2008 to a loss of $39 million in 2012. In terms of the Strategic Profit Model, Amazon’s profitability is marginal. Return on sales (ROS) fell from 3.4% in 2010, to 1.3% in 2011, to -0.06% in 2012. Asset turnover declined from 2.18 to 1.88, so that return on assets fell from 2.9% to -0.12%. Higher leverage meant that return on equity declined even more sharply, from 5.9% to -0.48%.

Amazon CEO Jeff Bezos has clearly and consistently stated that the company’s growth strategy is long term and that the most important financial metric for Amazon is free cash flow. Even by this metric, Amazon’s results are unlike any other retailers. While Amazon’s operating cash flow grew from $3.9 billion in 2011 to $4.2 billion in 2012, heavy capital expenditures resulted in a decline in free cash flow from $2 billion in 2011 to $600 million in 2012. Amazon’s challenge to existing retailers continues to grow, and is more difficult to address given its different operating and financial strategy.

Walmart, the world’s largest retailer, reported a 5% increase in sales to $469 billion; within two years it will become the first retailer to achieve a half-trillion dollars in sales. In contrast to Amazon, Walmart reported remarkably consistent margins and productivity results and achieved a return on equity of above 20% for the fifth straight year.

At the individual and sector level, there were mixed results in 2011. As the sluggish recovery and uncertain economic prospects continued, consumer habits established in the recession continued, such as trading down and being more price- and promotion-driven. Value retailers continued to report strong results. Costco reached $100 billion in sales for the first time, with improved returns and productivity compared to 2011. Financial results were especially strong at off-pricers and deep discounters TJX, Ross, Family Dollar, and Dollar Tree. TJX reported its fifth straight year of Return on Equity above 40%. Dollar Tree’s 12% sales increase and cost efficiencies resulted in a strong 37% return on equity, achieved with relatively low leverage.

In specialty apparel and softlines, Abercrombie and Fitch and Aeropostale continued to struggle. American Eagle was a bright spot, with sales growing 10%, return on sales increasing by 1.9%, and better productivity leading to return on equity almost doubling, from 11% to 19%. Gap’s turnaround efforts, which had stalled in 2011, appeared to get back on track. Gap saw 8% sales growth, an increase of 1% in return on sales, and an increase in return on equity from 24% to 39%—its best result in a decade.

In broadline retailing, Nordstrom sustained its strong performance and Macy’s turned in a consistent performance (sales up 5%), while maintaining margins and returns. Dillard’s, after struggling for many years, reported strong results as its five-year turnaround plan began to bear fruit. In contrast, Saks and Bon-Ton Stores continued to struggle. JC Penney fell off a cliff as it attempted a major repositioning, and Sears Holdings’ secular decline accelerated.

In technology, Best Buy and the office supply companies continued to face strong competition from Amazon. The long-term strategic problems of Office Depot and OfficeMax finally extended themselves to Staples, which reported declining sales, margins, and weak results overall. Surprisingly, the best result in office supply superstores was turned in by OfficeMax. In specialty retail, strong sales, profit, and return performances were shown by Tractor Supply, PetSmart, and Home Depot—each of which turned in results far ahead of their main competitors. Also notable was the continued strong performance of the leading automobile parts retailers Advance Auto Parts, AutoZone, and (slightly less so) by O’Reilly Automotive.

In food and drug, the results were again mixed, with a range of performances across all customer segments. Publix, Whole Foods, and Fresh Market reported continued strong results. Kroger appeared to be making real progress in becoming America’s largest supermarket chain. Turnarounds at Safeway and Weis Markets started to take hold, while Supervalu, Spartan, and Ingles struggled. In drugstores, Walgreen’s and CVS Caremark reported consistent performance relative to 2011, while Rite-Aid achieved profitability for the first time since 2007.

Table 2

International Retailers

Table 2 reports similar results for a group of major international retailers. Sixteen of the 30 retailers in Table 2 experienced increases in Return on Equity, although many of the changes were quite small.

The top spot on the list is held by H&M, whose 38% return on equity was the highest, although down slightly from past years. H&M was followed by Dairy Farm Group, part of Jardine Matheson, which operates food, pharmacy, and hypermarket formats in Asia.

H&M and Inditex (Zara and other brands) continued their strong performance in the fast fashion segment, although sales growth slowed, especially for H&M (up 7%, compared to Inditex up 14%). The profitability edge that had long been held by H&M was reversed in 2012, with Inditex now having higher return on sales. However, H&M’s higher productivity offset its lower leverage, resulting in a higher return on equity compared to Inditex.

For European retailers, the financial and economic problems from the euro crisis have started to show the same effects on retailers seen in the U.S. in 2007–2009.

The European food chains generally saw some improvement in performance, especially by Ahold, Sainsbury, and Morrison. Kingfisher’s turnaround also appeared to be making some progress. However, the performance of Tesco and Metro continued to be soft; each faces challenges in the home market by revitalized and low-priced value-driven competition, as well as weak performances in some other countries. Carrefour’s series of strategic restructurings appeared to be getting some traction, although the French home market continued to be a challenge. Japanese retailer Daiei again experienced major losses; indeed, the largest Japanese retailers continue to post weak results, with the notable exception of Seven-Eleven Japan, which continues to be the world’s premier convenience store chain.